What is Leverage? Learn About Leverage in Financial Trading

What is Leverage? Learn About Leverage in Financial Trading

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What is leverage? Leverage in Forex, Stocks, Crypto should be used like? How to best manage leveraged risk? How to play margin today?

What is leverage? What is Leverage?

Leverage, also known as financial leverage, is a form of allowing you to trade for more money than you currently have. Let’s say you have 100 USD, and the trading asset class can be leveraged up to 5 times, then you can place orders with up to 500 USD.

In financial investment, leverage is a popular and necessary tool, but how to use leverage properly is not always understood by all investors.

What is Leverage?
What is Leverage?

Some common problems with leverage include:

Risk of closing trade orders due to market movements in the opposite direction

Leverage interest rates for each type of trading asset are different

Leverage ratio in each type of market is different

When it comes to leverage, investors often say “leverage is a double-edged sword”, and in this article I will guide you how to use leverage most effectively, including how leverage works, how it works. margin trading, when to use leverage and how to manage risk.

Better understanding of leverage (Leverage)

In order to use leverage, brokers often require you to deposit a sum of money (called margin, or margin), to “believe” and assist you in making transactions with a larger value. Simply put, you will deposit a small amount of money in your trade, and the broker will lend you the rest.

The total value of your trade relative to the margin is called the leverage ratio.

Better understanding of leverage (Leverage)
Better understanding of leverage (Leverage)

For example, you want to buy 100 shares of A with broker X at the price of 100,000 VND per share.

In the usual way, you need to pay 10 million VND (100 x 100,000 VND) to buy this number of shares (excluding commissions and transaction fees).

If stock A increases in price by 10%, then each share A will cost 110,000 VND. Thus, you earn a profit of 1 million VND. The rate of return is 10%.

However, you can make this trade another way if the broker offers you leverage. Let’s say the broker offers a maximum leverage of 1:20 for stock A, which means you only need a 5% margin to buy the same number of shares.

At this time, you only need 500,000 VND to make a transaction. If stock A goes up 10%, you still make a profit of $1 million. The rate of return is 300%.

Types of Lever

Leverage is very common on derivatives markets like CFDs, meaning you can trade assets based on the underlying market, but not own the asset.

Besides the derivatives market, brokerage firms also provide leverage for other markets such as stocks, options, and ETFs on the underlying market.

These two types of leverage work in different ways, but they all have one thing in common: amplifying trade value, increasing the potential for both profit and risk.

Leveraged markets

You can trade leverage on various markets (assets):

Leverage in stock index

A stock index is a measure of the performance of a group of securities, a region, or a certain industry. Popular stock indexes in the world and in Vietnam include: SP500, Dowjone, Nasdaq, VN30.

Popular leverage ratio: 1:20

Leverage in Forex – Forex

Forex is the buying and selling of currency pairs for profit, is the largest global financial market. Every small movement on currency pairs can be profitable for investors when applying leverage.

Popular leverage ratio: 1:200

Cryptocurrency Leverage

Cryptocurrencies can be leveraged similar to the foreign exchange market, allowing investors to trade Bitcoin and Ethereum for larger amounts than they have.

Popular leverage ratio: 1:5

By now, you have understood how leverage works, and in which markets it can be used. Leverage is one of the most effective tools in trading indices, forex, and virtual currencies. Here are some advantages of leverage:

Profit amplification

You only need a small amount of money to trade on margin and can get the same amount of return as traditional investment.

Increase investment opportunities

Leverage will make your cash flow more abundant, can open more trades and more opportunities to make money.

Short selling

Leveraged derivatives also have another earning potential: Short Selling: You can make money in down markets by placing Sell first and Buy back orders later. This is called short selling.

Disadvantage of Lever

Besides the benefits, you also have to consider the downsides of leverage. Here are some issues you need to consider:

Risk amplification

Leverage can magnify both profits and risks, because your initial deposit is very small compared to the value of the trade, in a situation where the market moves in the opposite direction, you can run the risk of losing your money. account if risk management measures are not used. So in every leveraged trade, you must use risk management tools like Stop Loss, Stop Limit..

Does not own privileges like the underlying market

When trading leverage, it means that the privileges such as dividends (shares), shareholder voting rights, etc. are limited.

Margin call

A margin call occurs when the market moves in the opposite direction of your trade (say you place a buy order, but the market goes down), now you need to add more money to your account to maintain the order. transaction. If the balance in your account is not enough, you can exit the trade (actively) or be stopped from trading (due to a margin call by the exchange).

How to use leverage on different markets and practical experience

Since I am involved in investing in many different markets (stocks, crypto and Forex), I will share how to use the leverage I am applying.

How to use leverage in domestic stock trading

As you know, the domestic underlying stock market is in a sublimation stage, a lot of investors are trading on margin to enjoy this fever. According to statistics, the margin loan ratio in April reached 101.4 trillion VND, nearly touching the ceiling according to state regulations. This is a very alarming situation, a big risk when the market corrects.

How to use leverage in domestic stock trading
How to use leverage in domestic stock trading

If you want to trade local stocks using margin, you need to consider the following issues:

Choose a reputable broker (1) and have the lowest margin loan interest rate and most competitive transaction fees (2). For reference, the margin loan interest rate for Vietnamese securities is about 9% -18% depending on the brokerage company.

Determine your acceptable risk ratio. Assuming you invest 20 million VND in Vietnamese stocks and can accept up to 50% risk (lose 10 million), you can now use the leverage ratio according to the formula of New York University and AQR Capital Management:

Optimal leverage = 1/ [(risk)x(risk)] = 4 times.

Note: This ratio will be different for each investor, for an individual, I currently maintain a leverage ratio lower than 1:2 on the Vietnamese stock market.

How to use leverage in international stock trading

Currently, if you want to invest in international stocks, US stocks or stock indices, you can only invest in the form of CFD derivatives. In fact, it is almost impossible for Vietnamese to buy international securities on the underlying market.

The best way to play international stock margin, you need:

Choose a reputable international stock broker (licensed from FCA, ASIC, CySEC), competitive trading fees, no margin trading and low overnight fees.

While brokers offer maximum leverage ratios up to 1:20, you need to apply the optimal leverage ratio formula above to determine how much leverage to use.

How to use leverage in international stock trading
How to use leverage in international stock trading

How to use leverage in Forex trading

Forex is a very highly leveraged market that can go up to 1:3000. If you apply maximum leverage, I guarantee the majority of your trades can be met with margin calls within minutes of trading. Therefore, you need to use a lower leverage ratio. Here are a few tips on leverage ratios for newbies:

Main pairs: up to 1:5

Sub pairs: up to 1:3

(You can even trade with 1:1 leverage)

Risk management in leveraged trading

After knowing how to get the most out of leverage, the next thing you need to do is manage the risk in every trade. This problem is also very simple because most exchanges already provide many risk management tools available for you to use, such as:

Stop Loss Order

You set the price at which you expect to stop trading when the price drops to limit your losses. On the order placement panel, you can turn it on, off, and set the stop loss price very simply.

Take Profit order

You set the price at which you expect to stop trading when the price rises to take a profit. Take profit orders are also located in the order placement panel.

Price alert

You install asset price monitoring notifications, when the price reaches a certain threshold, you will receive a message to make a trading decision.

Limit Orders

You place buy and sell orders at the price you want to limit the disadvantage when the price fluctuates.

Negative Balance Protection tool

On some Forex brokers there is a built-in negative balance tool so your account won’t lose more than 0.

Conclude

Hopefully after this article, you will understand what leverage is. From a personal perspective, new investors should not use large leverage on all markets, only 1:2 should be enough. To get familiar with how to use leverage and master it, you should open a free Demo account to practice trading before using leverage in the real market!

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